Turn to the Software and Technology Exercise beginning with Section 9.3 End of Chapter Exercises.? You will create the EVA Spreadsheets and screenshot copy them to a Word.doc co

expert judgment

Decisions based on incomplete information made by people who have extensive personal experience.

scaled

Multiplied by an adjustment factor to make the new estimate proportional to the original.

analogous estimate

Budget estimate based on a similar project.

CHAPTER 9

Project Cost Management

An important part of a project manager’s job is managing project costs. All types of organizations must manage their money well in order to fulfill their mission, including not-for-profit and govern- ment organizations. The tools and methods used to manage project costs vary depending on the phase and complexity of the project. This chapter describes the methods used to estimate the cost of a project, create a budget, and manage the cost of activities during the life cycle of the project.

9.1 Estimating Costs

Learning Objectives

1. Describe methods of estimating costs.

2. Identify the effects of project phase and complexity on the choice of estimating method.

3. Describe the method of combining cost estimates with a schedule to create a budget.

Estimating Costs to Compare and Select Projects

Economic factors are an important consideration when choosing between competing projects. To compare the simple paybacks or internal rates of return between projects, an estimate of the cost of each project is made. The estimates must be accurate enough so that the comparisons are mean- ingful, but the amount of time and resources used to make the estimates should be appropriate to the size and complexity of the project. The methods used to estimate the cost of the project during the selection process are generally faster and consume fewer resources than those used to create detailed estimates for projects. They rely more on the expert judgment of experienced managers who can make accurate estimates with less detailed information. Estimates in the earliest stages of project selection are usually made using estimates based from previous projects that can be adjusted—scaled—to match the size and complexity of the current project or by applying stan- dardized formulas.

Analogous Estimate

An estimate that is based on other project estimates is an analogous estimate. If a similar project cost a certain amount, then it is reasonable to assume that the current project will cost about the same. Few projects are exactly the same size and complexity, so the estimate must be adjusted upward or downward to account for the difference. The selection of projects that are similar and the amount of adjustment needed is up to the judgment of the person who makes the estimate.

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parameters

Measurable factors that can be used in an equation to calculate a result.

parametric estimates

Estimates that are calculated by multiplying measured parameters by cost-per-unit values.

Normally, this judgment is based on many years of experience estimating projects, including incor- rect estimates that were learning experiences for the expert.

Analogous Estimate for John’s Move

In the John’s move example, John asked a friend for advice about the cost of his move. His friend replied, “I moved from an apartment a little smaller than yours last year and the distance was about the same. I did it with a fourteen-foot truck. It cost about $575 for the truck rental, pads, hand truck, rope, boxes, and gas.” Because of the similarity of the projects, John’s initial estimate of the cost of the move was less than $700 and he decided that the cost would be affordable and the project could go forward.

Less experienced managers who are required to make analogous estimates can look through the documentation that is available from previous projects. If those projects were evaluated using the Darnall-Preston Complexity Index (DPCI), the manager can quickly identify projects that have similar profiles to the project under consideration even if those projects were managed by other people. Comparing the original estimates with the final project costs on several previous projects with the same DPCI ratings gives a less experienced manager the perspective that it would take many years to acquire by trial and error. It also provides references the manager can use to justify the estimate.

Parametric Estimate

If the project consists of activities that are common to many other projects, average costs are avail- able per unit. For example, if you ask a construction company how much it would cost to build a standard office building, they will ask for the size of the building in square feet and the city in which the building will be built. From these two factors—size and location—the company’s estima- tor can predict the cost of the building. Factors like size and location are parameters—measurable factors that can be used in an equation to calculate a result. The estimator knows the average cost per square foot of a typical office building and adjustments for local labor costs. Other parameters such as quality of finishes are used to further refine the estimate. Estimates that are calculated by multiplying measured parameters by cost-per-unit values are parametric estimates.

Parametric Estimate for John’s Move

To estimate the size of the truck needed for John’s move, the parameter used by a truck rental company is the number of bedrooms, as shown below.

FIGURE 9.1 Number of Bedrooms Used for Parametric Cost Estimate

The moving company assumes that the number of bedrooms is the important parameter in determining how big a truck is needed for a move. For John’s move, he has a one-bedroom apart-

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request for proposal (RFP)

Requires a bidder to offer solutions and ideas on how to perform the scope of work and a price for performing that work.

qualified

Meets a standard of reliability and capability.

ment, so he chooses the fourteen-foot truck. Once the size is determined, other parameters, such as distance and days, are used to estimate the cost of the truck rental.

Estimating Costs to Initiate Projects

Once the project is selected, more accurate estimates are often needed to raise funds and agree on contracts with vendors during project initiation.

Estimate During the Initiation of John’s Move

John recalled that his friend also told him how tiring it was to do all the packing, loading, and driving himself, and some items were damaged when the load shifted inside the truck during the trip. John decides to call in favors from two friends, Dion and Carlita, to help him pack in Chicago and to hire some of the skilled labor to load the truck properly.

Vendor Bid Analysis

If services or products will be provided by vendors, the cost of those services can be determined by issuing a request for proposal (RFP). The RFP describes the work, service, or product to be pro- vided by the vendor and the quality level required. The RFP is sent to a list of vendors who are qualified—meet standards of reliability and capability—to perform this type of work. They respond with a proposal for completing the work described in the RFP, including an estimate of the cost. Some government organizations are required to use the qualified vendor with the lowest bid. Other organizations are not bound to take the lowest bid but are usually required to justify their reasons for not doing so.

Using RFPs to Make Estimates on John’s Move

John wants to find out how much it would cost to hire a skilled crew to load and secure the fur- niture in the truck and then have another crew from the same company meet him in Atlanta to unload the truck and help him unpack. He is not sure if any companies offer this option, so he decides to ask three moving companies for bids. He also decides to ask for bids on a standard move that includes all phases of packing, loading, transportation, and unloading as a comparison to see if his cost-saving plan is worth the extra effort.

The project management team can review the responses by several vendors to the RFP to determine if their estimate of the cost of that aspect of the project is close to the estimate made during the project selection. If the estimates by the vendors are much higher than expected, and if the project cannot be completed for the cost that was used to select the project, the selection decision might have to be reconsidered. Reconsidering the selection of the project should take into consideration the economic ratings of the competing projects that were not chosen and who the project champions are for the projects that would be affected.

Some vendors may suggest an alternative way to meet the objective of the RFP in a more cost- effective manner that does not match the specifics of the RFP. Such alternatives can reduce costs if they are acceptable.

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bottom-up estimating

Summing of estimates of each detail of the activity and project.

rolled up

Subtotaled.

Bottom-Up Estimating

The most accurate and time-consuming estimating method is to identify the cost of each item in each activity of the schedule, including labor and materials. If you view the project schedule as a hierarchy where the general descriptions of activities are at the top and the lower levels become more detailed, finding the price of each item at the lowest level and then summing them to deter- mine the cost of higher levels is called bottom-up estimating.

Bottom-Up Estimate for John’s Move

After evaluating the bids by the moving companies, John decides the savings are worth his time if he can get the packing done with the help of his friends. He decides to prepare a detailed esti- mate of costs for packing materials and use of a rental truck. He looks up the prices for packing materials and truck rental costs on company websites and prepares a detailed list of items, quan- tities, and costs, as shown below.

FIGURE 9.2 Detailed Cost Estimate This type of estimate is typically more accurate than an analogous or parametric estimate. In this example, the sum of packing materials and truck expenses is estimated to be $661.25.

The detail can be rolled up—subtotaled—to display less detail. This process is made easier using computer software. On projects with low complexity, the cost estimates can be done on spreadsheet software.

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Rolling Up a Detailed Cost Estimate for John’s Move

For example, the subtotal feature could be used in Excel and collapsed to show the subtotals for the two categories of costs, as shown below.

FIGURE 9.3 Sum of Detailed Costs by Type

On larger projects, software that manages schedules can also manage costs and display costs by activity and by category.

Activity-Based Estimates

An activity can have costs from more than one vendor plus costs for labor and materials from internal sources. Detailed estimates from all sources can be reorganized so those costs that are associated with a particular activity can be grouped by adding the activity code to the detailed esti- mate, as shown in Figure 9.4.

FIGURE 9.4 Detailed Costs Associated with Activities The detailed cost estimates can be sorted by activity and then subtotaled by activity to determine the cost for each activity.

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cost aggregation

Sum of component costs.

reconciliation

Matching funds provided with funds spent.

Establishing a Budget

Once the cost of each activity is estimated, it is possible to determine how much money is needed for each group of tasks and for the whole project.

Cost of Activities

The cost of each group of activities of the project can be estimated by summing the costs of the components of each activity in the group. This process of subtotaling costs by category or activity is called cost aggregation.

Budget Timeline

Because the costs are associated with activities and each activity has a start date and a duration, it is possible to calculate how much money needs to be spent by any particular date during the pro- ject. The money needed to pay for a project is usually transferred to the project account shortly before it is needed. These transfers must be timed so that the money is there to pay for each activ- ity without causing a delay in the start of the activity. If the money is transferred too far in advance, the organization will lose the opportunity to use the money somewhere else, or they will have to pay unnecessary interest charges if the money is borrowed. A schedule of money transfers is cre- ated that should match the need to pay for the activities. The process of matching the schedule of transfers with the schedule of activity payments is called reconciliation. Refer to Figure 9.5, which shows the costs of ten major activities in a project. Funds are transferred into the project account four times. Notice that during most of the project, there were more funds available than were spent except at activity 6 when all the available funds were spent.

FIGURE 9.5 Fund Transfers and Expenditures

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In the project budget profile shown in Figure 9.5, there is no margin for error if the total of the first six activities exceeds the amount of funding at that point in the project.

Contractual agreements with vendors often require partial payment of their costs during the project. Those contracts can be managed more conveniently if the unit of measure for partial com- pletion is the same as that used for cost budgeting. For example, if a contractor is pouring concrete for a large project, the contract may call for partial payment after 25 percent of the total volume of concrete is poured as determined by cubic yards of concrete.

Key Takeaways

• Analogous estimating scales an estimate from a similar project to match the current project. Parametric estimating multiplies a standard cost-per-unit value by the number of units in the project. Bids from contractors can be compared to estimate costs. Bottom-up estimating determines the cost of each detail and aggregates them to determine activity cost estimates.

• During the project selection and approval stage, rough estimates are used that are usually obtained using analogous and parametric methods. Vendor bid analysis and detailed bot- tom-up estimates are used in the initiation phase to estimate project costs.

• Detailed estimates are associated with activities and aggregated during the planning phase to create an activity-based budget. Funding transfers are arranged to reconcile money spent to money from funding sources in a timely manner.

Exercises

1. An estimate that is obtained by scaling up an estimate from a similar project is a(n) ___________ estimate.

2. An estimate that uses standard costs per unit such as price per square foot or price per cubic yard is a ____________ estimate.

3. Matching the transfer of funds into the project account with the money spent is called __________________.

EstimatesEstimates

Consider a project in which you have been involved that used an estimating technique to provide numbers for the conceptual plan. Briefly describe the type of project and identify the estimating method used.

9.2 Managing the Project Budget

Learning Objectives

1. Describe methods to manage cash flow.

2. Describe the terms and relationships of budget factors used in earned value analysis.

3. Calculate and interpret budget and schedule variances.

4. Calculate and interpret the schedule performance index and the cost performance index.

5. Calculate and interpret estimates to complete the project.

6. Calculate the revised final budget.

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contingency reserves

Money held to pay for predictable but unspecified extra costs.

management reserves

Money that is available for changes that develop from unforeseen work that is within the scope of the project.

Projects seldom go according to plan in every detail. It is necessary for the project manager to be able to identify when costs are varying from the budget and to manage those variations.

Managing Cash Flow

If the total amount spent on a project is equal to or less than the amount budgeted, the project can still be in trouble if the funding for the project is not available when it is needed. There is a natural tension between the financial people in an organization, who do not want to pay for the use of money that is just sitting in a checking account, and the project manager, who wants to be sure that there is enough money available to pay for project expenses. The financial people prefer to keep the company’s money working in other investments until the last moment before transfer- ring it to the project account. The contractors and vendors have similar concerns, and they want to get paid as soon as possible so they can put the money to work in their own organizations. The pro- ject manager would like to have as much cash available as possible to use if activities exceed budget expectations.

Contingency Reserves

Most projects have something unexpected occur that increases costs above the original estimates. If estimates are rarely exceeded, the estimating method should be reviewed because the estimates are too high. It is not possible to predict which activities cost more than expected, but it is reason- able to assume that some of them will be. Estimating the likelihood of such events is part of risk analysis, which is discussed in more detail in a later chapter.

Instead of overestimating each cost, money is budgeted for dealing with unplanned but statis- tically predictable cost increases. Funds allocated for this purpose are called contingency reserves.[1] Because it is likely that this money will be spent, it is part of the total budget for the project. If this fund is adequate to meet the unplanned expenses, then the project will be completed within the budget.

Management Reserves

If something occurs during the project that requires a change in the project scope, money may be needed to deal with the situation before a change in scope can be negotiated with the project spon- sor or client. It could be an opportunity as well as a challenge. Money can be made available to the project to be used at the discretion of the manager to meet needs that would change the scope of the project. These funds are called management reserves. Unlike contingency reserves, they are not likely to be spent and are not part of the project’s budget baseline, but they can be included in the total project budget.[2]

Evaluating the Budget During the Project

A project manager must regularly compare the amount of money spent with the budgeted amount and report this information to managers and stakeholders. It is necessary to establish an under- standing of how this progress will be measured and reported.

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earned value management (EVM)

Method of comparing the budgeted and actual costs of a project during the project.

budgeted cost of work scheduled (BCWS)

All the items in the cost estimate. See budget at completion (BAC).

planned value (PV)

Sum of the items in the budgeted cost of work scheduled that should have been spent by a particular day.

Reporting Budget Progress on John’s Move

In the John’s move example, he estimated that the move would cost about $1,500 and take about sixteen days. Eight days into the project, John has spent $300. John tells his friends that the project is going well because he is halfway through the project but has only spent a fifth of his budget. John’s friend Carlita points out that his report is not sufficient because he did not compare the amount spent to the budgeted amount for the activities that should be done by the eighth day.

As John’s friend points out, a budget report must compare the amount spent with the amount that is expected to be spent by that point in the project. Basic measures such as percentage of activ- ities completed, percentage of measurement units completed, and percentage of budget spent are adequate for less complex projects, but more sophisticated techniques are used for projects with higher complexity.

Earned Value Management

A method that is widely used for medium- and high-complexity projects is the earned value management (EVM) method. EVM is a method of comparing the budgeted and actual costs of a project periodically during the project. It combines the scheduled activities with detailed cost esti- mates of each activity. It allows for partial completion of an activity if some of the detailed costs associated with the activity have been paid but others have not. The earned value analysis method compares the anticipated cost of work that is scheduled to be done at a given point in time against what has been done and how much it actually cost.

The Budgeted Cost of Work and Planned Value

The budgeted cost of work scheduled (BCWS) comprises the detailed cost estimates for each activ- ity in the project. The amount of work that should have been done by a particular date is the planned value (PV). These terms are used interchangeably by some sources, but the planned value term is used in formulas to refer to the sum of the budgeted cost of work up to a particular point in the project, so we will make that distinction in the definitions in this text for clarity.

Planned Value on Day Six of John’s Move

On day six of the project, John should have taken his friends to lunch and purchased the packing materials. The portion of the BCWS that should have been done by that date (the planned value) is listed in Figure 9.6. This is the planned value for day six of the project.

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budgeted cost of work performed (BCWP)

The budgeted cost of work scheduled that has been done.

earned value (EV)

Sum of budgeted expenses up to a particular point in the schedule.

actual cost (AC)

Sum of money spent so far.

FIGURE 9.6 Planned Value for Lunch and Packing Materials

Budgeted Cost of Work Performed and Earned Value

The budgeted cost of work performed (BCWP) is the budgeted cost of work scheduled that has been done. If you sum the BCWP values up to that point in the project schedule, you have the earned value (EV).

Actual Cost

The amount spent on an item is often more or less than the estimated amount that was budgeted for that item. The actual cost (AC) is the sum of the amounts actually spent on the items.

Comparing PV, EV, and AC in John’s Move on Day Six

Dion and Carlita were both trying to lose weight and just wanted a nice salad. Consequently, the lunch cost less than expected. John makes a stop at a store that sells moving supplies at dis- count rates. They do not have all the items he needs, but the prices are lower than those quoted by the moving company. They have a very good price on lifting straps so he decides to buy an extra pair. He returns with some of the items on his list, but this phase of the job is not complete by the end of day six. John bought half of the small boxes, all of five other items, twice as many lifting straps, and none of four other items. John is only six days into his project, and his costs and performance are starting to vary from the plan. Earned value analysis gives us a method for reporting that progress. Refer to the figure below.

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variance

Difference between estimated and actual.

schedule variance (SV)

Difference between the earned value (EV) and the planned value (PV).

Project Earned Value Analysis – Day 6

Budgeted Cost of WorkBudgeted Cost of Work Scheduled (BCWS)Scheduled (BCWS)

Budgeted Cost of WorkBudgeted Cost of Work Performed (BCWP)Performed (BCWP)

Actual Cost

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