Project cost management
Chapter 9

Horror stories of project failures due to extraordinary
cost overruns are reported in the business press on
almost a daily basis

As a general rule, management and customers
are always concerned with how much a project is
going to cost in relation to how much a project is
going to earn

Project cost management
• Includes processes involved in planning,
estimating, budgeting, financing, funding,
managing, and controlling costs so that the project
can be completed within the approved budget

Why Do We Manage Cost?
• Part of triple constraint, can’t manage one without
the others (scope, time, and quality)
• Plots of cost and scope against plan can help spot
problems early
Cumulative
Value
Time
Planned
Value (PV)
Actual
Costs (AC)
Earned
Value (EV)
Today
Is this project
over/under budget?
Is it ahead of/behind
schedule?

Project cost management processes
• Plan cost management—establishes the policies,
procedures, and documentation for planning,
managing, expending, and controlling project costs
• Estimate costs—an approximation of the monetary
resources needed to complete project activities
• Determine budget— aggregating the estimated costs
of individual activities or work packages to establish
an authorized cost baseline
• Control costs—monitoring the status of the project to
update the project costs and managing changes to
the cost baseline

Importance of cost estimation
• Provides standard against which actual expenditures
incurred during the course of a project can be
compared, and serve as the basis for cost control
• They provide the mechanism for managing cash flow
during the course of the project
• They give the project manager a framework for
allocating scarce resources as the project progresses

Errors during project progress
Potential for errors in estimates during the various stages of
the project progress

Classification of project costs
• Direct Vs. Indirect
• Recurring Vs. Nonrecurring
• Fixed Vs. Variable
• Normal Vs. Expedited

Direct Vs. Indirect
• Direct costs- can be directly charged against the
project; for example, the costs of personnel who
are directly involved in the project, or the costs of
materials directly used for project work
• Indirect costs- include overhead, as well as
selling and administrative expenses
Examples of overhead costs include costs associated
with taxes, insurance, utilities, and so forth. Costs
associated with selling and administrative expenses,
commissions, advertising, etc

Recurring Vs. Nonrecurring
• Recurring costs- such as labor and materials,
are repeatedly incurred throughout the project
life cycle
• Nonrecurring costs- are one-time costs that are
typically incurred at the beginning or at the end
of the project, such as market research and
labor training

Fixed Vs. Variable
• Fixed costs- do not vary with usage. Example,
costs incurred in the purchase of capital
equipment remain fixed, regardless of the extent
of equipment use
• Variable costs- vary directly with usage. They are
typically associated with labor and materials

Normal Vs. Expedited
• Normal costs- are incurred when project tasks are
completed according to the original planned
duration
• Expedited costs- or crash costs are unplanned
costs incurred as a result of steps taken to
accelerate project completion
Example, costs associated with using additional overtime
or hiring additional workers specifically to hasten project
completion can be regarded as expedited costs

Cost classifications
Direct labor X X X X
Building lease X X X X
Expedite X X X X
Material X X X X
Direct
Indirect
Fixed
Recurring
Variable
Normal
Expedited
Costs
Non-recurring

Cost estimating methods
• Ballpark estimates
• Feasibility estimates
• Definitive estimates
• Comparative estimates

Ballpark estimates
• Also known as ‘‘order of magnitude’’ estimates,
often used when there is not sufficient information
or time available
• Typically, used for making competitive bids for
project contracts, or for initial rough-cut estimates
of resources needed for a project
• As a general rule, ballpark estimates should
attempt an accuracy of ±30 percent

Feasibility estimates
• Are developed after preliminary project design
work is completed
• Are often used in construction projects, where
published information on material costs is widely
available
• As more relevant information becomes available
further down the project life cycle, the ±10 percent
margin of error

Definitive estimates
• Can be developed only after the completion of
most design work
• Clear understanding of the scope and capabilities
of the project, changes to project specifications
are virtually nonexistent
• Developed further down the project life cycle with
more accurate information and fewer project
uncertainties, provide a much more accurate
expected cost of the project at completion, with a
±5 percent margin of error

Comparative estimates
• Uses historical data from previous project activities
as the frame of reference for current estimates
• One of the method is parametric estimation-most
projects are similar to previous projects by way of
similar features or parameters and, therefore, are
likely to incur similar costs. Steps:
– Identifying the features/parameters of an older or well-known
project that can be directly related to the cost of the current
project
– Defining the mathematical nature of that relationship

Use of learning curves in estimation
• Human performance usually improves
when a task is repeated
• This happens by a fixed percent each
time the production doubles
• Percentage is called the learning rate

Learning curve calculations
( )
∑=
=
=
=
N
n
r
r
n
nT
rate
r
nTT
1
1
1
timeTotal
2log
log
Tn = Time for nth unit
T1 = Time for first unit
N = Number of units
R = log decimal rate/log 2
One worker will be tasked to produce all 25 units of air filters. In
addition, after production of the 20th unit, there is no significant
time reduction associated with learning, and production reaches
a steady state of 70 hours. Learning rate is 85%. Time to
complete the first activity?
r = log 0.85/ log 2
r= −0.1626/0.693
r= −0.235
70 hours = T1 ( 20)-0.235
T1= 141.3 hours

Cost estimation and budgeting
• Cost estimation and project budgeting are
closely linked
• Without reasonable cost estimation, project
budgets are essentially useless, and without
accurate budgeting, cost estimation is a
wasted exercise

Budgeting
• A plan for the costs of project resources
• A budget implies constraints
• Thus, it implies that managers will not
get everything they want or need

Budgeting
• The budget for an activity also implies
management support for that activity
• Higher the budget, relative to cost, 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

Issues in project budgeting
• A project budget identifies the project’s
allocated resources, goals, and the schedule
that allows the organization to achieve those
goals
• Developing a project budget requires not only a
knowledge of the resources needed, but also
information regarding how many will be needed
and when, as well as how much they will cost

Estimating project budgets
• On most projects
– Material + Labor + Equipment + Capital +
Overhead + Profits = Bid
• In other words
– Resources + Profits = Bid
• So we are left with the task of forecasting
resources

Estimating project budgets
• Like any forecast, this includes some
uncertainty
• There is uncertainty regarding usage
and price
– Especially true for material and labor
• The more standardized the project and
components, the lower the uncertainty
• The more experienced the cost
estimator, the lower the uncertainty

Rule of thumb
• Some estimates are prepared by rules
of thumb
• Construction cost by square feet
• Printing cost by number of pages
• Lawn care cost by square feet of lawn
• These rules of thumb may be adjusted
for special conditions
• However, this is still easier than starting
the estimate from scratch

Difficulties
• There may not be as much historical
data or none at all
• Even with similar projects, there may
be significant differences
• Many people have input and some
control over the budget

Difficulties
• There is more “flexibility” regarding the
estimates of inputs (material and labor)
• The accounting system may not be set
up to track project data
• Usage of labor and material is very
lumpy over time

Types of budgeting
• Top-down
• Bottom-up
• Negotiated
• Activity based costing

Top-down
• Top managers estimate/decide on the
overall budget for the project
• These trickle down through the
organization where the estimates are
broken down into greater detail at each
lower level
• The process continues to the bottom
level

Advantages
• Overall project budgets can be set/controlled very
accurately
• Management has more control over budgets
Disadvantages
• More difficult to get buy in
• Leads to low level competition for larger shares of
budget

Bottom-up budgeting
• Project is broken down into work packages
• Low level managers price out each work
package
• Overhead and profits are added to develop
the budget

Advantages
• Greater buy in by low level managers
• More likely to catch unusual expenses
• People tend to overstate their budget
requirements
• Management tends to cut the budget
Disadvantages

An iterative budgeting process–
negotiation-in-action
• Most projects use some combination of
top-down and bottom-up budgeting
• Both are prepared and compared
• Any differences are negotiated

Snapshot
from practice
How do you estimate the
cost of a nuclear power
plant?

Activity based costing
• Activity-based costing (ABC) is frequently
used for project budgeting. The basis of
activity-based costing is that projects
consume activities, and activities consume
resources

Steps in activity-based costing
• Assign costs to activities that use resources
(costs are assigned to each work package)
• Identify cost drivers associated with this
activity( like human resource in many cases)
• Compute a cost rate per cost driver unit or
transaction (cost of labor per hour)
• Multiply the cost driver rate times the volume of
cost driver units used by the project
Rs50/hour 100 hours = Rs5,000.00∗

Budget contingencies
• The allocation of extra funds to cover uncertainties
and improve the chance of finishing on time
• It is an important aspect of project finance,
because it provides a certain amount of protection
against unknown and uncertain elements that can
derail a project

Contingencies are needed because
• Project scope may change
• Murphy’s Law is present
“If anything can go wrong, it will”
• Cost estimation must anticipate interaction costs
Hidden cost
• Normal conditions are rarely encountered

Benefits to include contingency
• Recognizes that the future is uncertain, and
that unexpected problems can increase
overall project costs
• Contingency estimates make explicit
provisions for potential and unexpected cost
increase in project plans and budgets
• The use of contingency funds provides an
early warning signal of potential cost overruns

More on Project Cost
Management

Cost Management Key Terms
• PV - Planned Value, estimated value of the planned work
• EV – Earned Value, estimated value of work done
• AC – Actual Cost, what you paid
• BAC – Budget at Completion, the budget for the total job
• EAC –Estimate at Completion, what is the total job
expected to cost?
• ETC – Estimate to Complete, forecasted costs to complete
job
• VAC – Variance at Completion, how much over/under
budget do we expect to be?

How Do We Manage Cost?
• Three processes
– Estimate Costs
– Determine Budget
– Control Costs
Estimate
Costs
Determine
Budget
Control
Costs

Estimate Costs
Enterprise
Environmental
Factors
Organizational
Process Assets
Project Scope
Statement
Analogous estimating
Determine resource cost
rates
Bottom up estimating
Parametric estimating
Project management
software
Vendor bid analysis
Reserve analysis
Cost of quality
Inputs
OutputsTools & Techniques
Work Breakdown
Structure
WBS Dictionary
Project
Management Plan
•Schedule Mgmt Pln
•Staffing Mgmt Pln
•Risk Register
Activity Cost
Estimates
Activity Cost
Estimates
Supporting Detail
Requested Changes
Cost Management
Plan Updates
Estimate
Costs
Determine
Budget
Control
Costs

Other Estimating Methods
• Parametric estimating – Use mathematical model
(i.e. cost per sq ft). [accuracy varies] Two types:
• Regression analysis – based on analysis of multiple
data points
• Learning Curve – The first unit costs more than the
100th
, forecasts efficiency gains
• Vendor Bid Analysis – Estimating using bids +
allowances for gaps in bid scope [slow, accuracy
depends on gaps]
• Reserve Analysis – Adding contingency to each
activity cost estimates as zero duration item [slow,
overstates cost]

Determine Budget
Project Scope Statement
Cost aggregation
Reserve analysis
Parametric estimating
Funding limit reconciliationInputs
Outputs
Tools & Techniques
Cost Baseline
Project Funding
Requirements
Cost Management
Plan Updates
Requested Changes
Work Breakdown Structure
WBS Dictionary
Activity Cost Estimates
Activity Cost Estimates
Supporting Detail
Project Schedule
Resource Calendars
Contract
Cost Management Plan
Estimate
Costs
Determine
Budget
Control
Costs

Determine Budget
• Budgeting is allocating costs to work
packages to establish a cost baseline to
measure project performance
• Remember Contingency items are for
unplanned but required changes it is not to
cover things such as:
– Price escalation
– Scope & Quality Changes
• Funding Limit Reconciliation – Smoothing out
the project spend to meet management
expectations

Control Costs
Cost Baseline
Project Funding
Requirements
Performance
Reports
Cost change control system
Performance measurement
analysis
Forecasting
Project performance reviews
Project management
software
Variance management
Inputs
OutputsTools & Techniques
Work Performance
Information
Approved Change
Requests
Project
Management Plan
Cost Estimate
Updates
Cost Baseline
Updates
Performance
Measurements
Forecasted
Completion
Requested Changes
Recommended
Corrective Actions
Organizational
Process Assets
Updates
Project Management
Plan Updates
Estimate
Costs
Determine
Budget
Control
Costs

Earned Value
• Progress is compared against the
baseline to determine whether
project is ahead of or behind plan
• Percent complete can be difficult to
measure, some managers use
rules
– 50/50 Rule – Assumed 50% complete
when task started, final 50% at
completion
– 20/80 Rule – 20% at start
– 0/100 Rule – No credit until complete
• Planned Value
(PV) – Budgeted
Cost
• Earned Value
(EV) – Actual
work completed
• Actual Cost (AC)
– Costs incurred
• Estimate to
Complete (ETC)
– What’s Left
• Estimate at
Completion
(EAC) – What
final cost will be

Earned
Value
Graph
Variance at
Completion
(VAC)
Target
Cost &
Schedule
Schedule
Variance
(Time)
Planned
Value
(PV)
Earned
Value
(EV)

Earned Value Formulas
NAME FORMULA NOTES
Cost Variance (CV) EV-AC Negative = Over budget
Positive = Under budget
Schedule Variance
(SV)
EV-PV Negative = Behind Schedule
Positive = Ahead of Schedule
Cost Performance
Index (CPI)
EV/AC How much are we getting for every
dollar we spend?
Schedule Perform
Index (SPI)
EV/PV Progress as % against plan
Estimate to Complete
(ETC)
EAC-AC How much more do we have to
spend?
Variance at
Completion (VAC)
BAC-EAC At the end of the day, how close will
we be to plan?
Estimate at
Completion (EAC)
See following slide

Earned Value Formulas (Cont’d)
NAME FORMULA NOTES
Estimate at
Completion (EAC)
•BAC/CPI Use if no variances from
BAC have occurred
•AC+ATC Use when original
estimate was bad. Actuals
+ New estimate
•AC+BAC-EV Use when current
variances are not expected
to be there in the future
•AC+(BAC-EV)/CPI Use when current
variances are expected to
continue

Tricks for Earned Value
• EV is always first
• Variance = EV minus something
• Index = EV divided by something
• If the formula relates to cost use AC
• If the formula relates to schedule use PV
• Interpreting results: negative is bad and positive is
good
• Interpreting results: greater than one is good, less
than one is bad
PV
AC ETC
EAC
BAC
Project
Start
Current
Status

Terms to Remember
• Present Value
• Net Present Value (NPV)
• Internal Rate of Return
(IRR)
• Payback Period
• Benefit Cost Ratio =
BCR>1, Payback is greater
than the cost
• Opportunity Cost
• Sunk Cost
• Working Capital
• Straight Line Depreciation
• Accelerated Depreciation
• Double Declining Balance
• Sum of Years Digits
• Value Analysis (Value
Engineering)

• To illustrate the concept of EVM and all the
formulas, assume a project that has exactly
one task. The task was baselined at 8 hours,
but 11 hours have been spent and the
estimate to complete is 1 additional hour. The
task would have been completed already.
Assume an Hourly Rate of $100 per hour.

• Budget at Completion
(BAC) is the total budget
allocated to the project.
• Estimate to Complete
(ETC) is the estimated
cost required to complete
the remainder of the
project.
• Estimate at Completion
(EAC) is the estimated
cost of the project at the
end of the project.
• Variance at completion
(VAC) is the variance on
the total budget at the end
of the project.

Appendices

Sample project
activity cost
estimating sheet

Sample budget showing planned and
actual activity costs and variances

Sample of a time-phased budget

Calculating direct labor costs