Chapter Four: Project Cost Management

4.1 Introduction, Importance and Principles of Project Cost Management

Activity
Explain what happens during project budgeting?
Why is it important to estimate cost and manage it?

IT projects have room for improvement in meeting cost goals. In project cost management,
particularly planning cost management, creating good estimates, and using earned value
management (EVM) to assist in cost control.

What is the Cost?

 “Accountants usually define cost as a resource sacrificed or foregone to achieve a specific

objective.”
 Webster’s dictionary defines cost as “something given up in exchange.” Costs are often
measured in monetary amounts, such as dollars, that must be paid to acquire goods and services.

What is Project Cost Management?

Project cost management includes the processes required to ensure that a project team completes
a project within an approved budget. Notice two crucial phrases in this definition: “a project” and
“approved budget.” 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 four processes for project cost management:

1. Planning cost management involves determining the policies, procedures, and documentation
that will be used for planning, executing, and controlling project costs. The main output of this
process is a cost management plan.
2. 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, the basis of estimates, and project documents updates.
3. 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 baseline, project funding requirements, and project documents updates.
4. Controlling costs involves controlling changes to the project budget. The main outputs of the
cost control process are work performance information, cost forecasts, change requests, project
management plan updates, project documents updates, and organizational process assets updates

Basic Principles of Cost Management

 Profits – are revenues minus expenditures. To increase profits, a company can increase
revenues, decrease expenses, or try to do both. Most executives are more concerned with profits
than with other issues. When justifying investments in new information systems and technology,
it is important to focus on the impact on profits, not just revenues or expenses. You cannot
measure the potential benefits of the application without knowing the profit margin. Profit
margin is the ratio of revenues to profits. If revenues of $100 generate $2 in profits, there is a 2
percent profit margin. If the company loses $2 for every $100 in revenue, 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 project’s financial costs and
benefits. It considers the total cost of ownership, or development plus support costs, for a project.

Example:
A company might complete a project to develop and implement a new customer service system
in one or two years, but the new system could be in place for 10 years.

 Cash Flow Analysis – is a method for determining the estimated annual costs and benefits of a
project and the resulting annual cash flow. Project managers must conduct cash flow analysis to
determine net present value. Most consumers understand the basic concept of cash flow: If they
do not have enough money in their wallets or bank accounts, they cannot purchase something.
Top management must consider cash flow concerns when selecting projects in which to invest. If
top management selects too many projects that have high cash flow needs in the same year, the
company will not be able to support all of its projects and maintain its profitability. It is also
important to clarify the year used to analyze dollar amounts.
 Tangible Costs or Benefits – can easily be measured in dollars.
 Intangible Costs or Benefits – are difficult to measure in monetary terms. Intangible benefits
for projects often include items like goodwill, prestige, and general statements of improved
productivity that an organization cannot easily translate into dollar amounts. Because intangible
costs and benefits are difficult to quantify, they are often harder to justify.
 Direct Costs – can be directly related to creating the products and services of the project. You
can attribute direct costs to a certain project.

Example:
It includes the salaries of people working full time on the project and the cost of hardware and
software purchased specifically for the project. Project managers should focus on direct costs
because they can be controlled.

 Indirect Costs – are not directly related to the products or services of the project, but are
indirectly related to performing the project.

Example:
It would include the cost of electricity, paper towels, and other necessities in a large building that
houses 1,000 employees who work on many projects. Indirect costs are allocated to projects, and
project managers have very little control over them.

 Sunk Cost – is money that has been spent in the past. Consider it gone, like a sunken ship that
can never be raised. When deciding what projects to invest in or continue, you should not include
sunk costs. It should be forgotten, even though it is often difficult to think that way.
 Learning Curve Theory – states that when many items are produced repetitively, the unit cost
of those items decreases in a regular pattern as more units are produced.

Example: –
Suppose that the Surveyor Pro project would potentially produce 1,000 handheld devices that
could run the new software and access information via satellite. The cost of the first handheld
unit would be much higher than the cost of the thousandth unit.
 Reserves – are dollar amounts included in a cost estimate to mitigate cost risk by allowing for
future situations that are difficult to predict.

Contingency reserves allow for future situations that may be partially planned for (sometimes
called known unknowns) and are included in the project cost baseline.

Example: – If an organization knows it has a 20 percent rate of turnover for IT personnel, it

should include contingency reserves to pay for recruiting and training costs of IT personnel.

Management reserves allow for future situations that are unpredictable (sometimes called
unknown unknowns). Example: – If a project manager gets sick for two weeks or an important
supplier goes out of business, management reserve could be set aside to cover the resulting costs.
Management reserves are not included in a cost baseline.

4.2 Planning Cost Management

It is the first step that helps how the costs will be managed throughout the life of the project.
Project costs, like project schedules, grow out of the basic documents that initiate a project, like a
project charter. The project manager and other stakeholders use expert judgment, analytical
techniques, and meetings to produce the cost management plan.

A cost management plan includes the following information:

 Level of Accuracy – activity cost estimates normally have rounding guidelines, such as rounding
to the nearest $100. There may also be guidelines for the number of contingency funds to
include, such as 10 or 20 percent.
 Units of Measure – each unit used in cost measurements, such as labor hours or days, should be
defined.
 Organizational Procedures Links – many organizations refer to the WBS component used for
project cost accounting as the control account (CA). Each control account is often assigned a
unique code that is used in the organization’s accounting system. Project teams must understand
and use these codes properly.
 Control Thresholds – similar to schedule variance, costs often have a specified amount of
variation allowed before action needs to be taken, such as ±10 percent of the baseline cost.
 Rules of Performance Measurement – if the project uses earned value management (EVM) the
cost management plan would define measurement rules, such as how often actual costs will be
tracked and to what level of detail.
 Reporting Formats – it would describe the format and frequency of cost reports required for the
project.
 Process Descriptions – the cost management plan would also describe how to perform all of the
cost management processes.

4.3 Cost Estimating

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.

Types of Cost Estimates

one of the main outputs of project cost management is a cost estimate. Project managers
normally prepare several types of cost estimates for most projects. Three basic types of estimates
include the following:

A. A rough order of magnitude (ROM) estimate provides an estimate of what a project will
cost. A ROM estimate can also be referred to as a ballpark estimate, a guesstimate, a swag, or a
broad gauge. 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.

Example:
The actual cost for a project with a ROM estimate of $100,000 could range from $50,000 to
$200,000. Many IT professionals automatically double estimates for software development
because of the history of cost overruns on IT projects.
B. A budgetary estimate is used to allocate money into an organization’s budget. Many
organizations develop budgets at least two years into the future. Budgetary estimates are made
one to two years prior to project completion. 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.

Example:
The actual cost for a project with a budgetary estimate of $100,000 could range from $90,000 to
$125,000.

C. A definitive estimate 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.

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.

Definitive estimates are made one year or less prior to project completion. A definitive estimate
should be the most accurate of the three types of estimates. 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.

Example:
The actual cost for a project with a definitive estimate of $100,000 could range from $95,000 to
$110,000.
The following summarizes the three basic types of cost estimates.

Table 4.1:- cost estimates

4.4 Cost Budgeting

Determining the budget involves allocating the project cost estimate to individual material
resources or work items over time. These material resources or work items are based on the
activities in the work breakdown structure for the project. The cost management plan, scope
baseline, activity cost estimates, basis of estimates, project schedule, resource calendars, risk
register, agreements, and organizational process assets are all inputs for determining the budget.
The main goal of the cost budgeting process is to produce a cost baseline for measuring project
performance and determining project funding requirements.

The process may also result in project document updates, such as items being added, removed, or
modified in the scope statement or project schedule. A cost baseline is a time-phased budget that
project managers use to measure and monitor cost performance.

4.5 Cost Control

Controlling project costs include 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 information, cost forecasts,
change requests, project management plan updates, project document updates, and organizational
process asset updates. Many general accounting approaches are available for measuring cost
performance; earned value management (EVM) is a powerful cost control technique that is
unique to the field of project management.

Earned Value Management (EVM)

It is a project performance measurement technique that integrates scope, time, and cost data.
Given a cost performance baseline, project managers and their teams can determine how well the
project is meeting scope, time, and cost goals by entering actual information and then comparing
it to the baseline.

A baseline is a figure in the original project plan plus approved changes. Actual
information includes whether or not a WBS item was completed, approximately how much of
the work was completed, when the work actually started and ended, and how much the
completed work actually cost. The accuracy of calculating earned value is simply by multiplying
the planned value to date by a percentage complete value. Earned value management involves
calculating three values for each activity or summary activity from a project’s WBS.

A. The Planned Value (PV), also called the budget, is the portion of the approved total cost
estimate planned to be spent on an activity during a given period. Table 4.2 shows an example of
earned value calculations. Suppose that a project included a summary activity of purchasing and
installing a new Web server. Suppose further that, according to the plan, it would take one week
and cost a total of $10,000 for the labor hours, hardware, and software. Therefore, the planned
value (PV) for the activity that week is $10,000.

B. The Actual Cost (AC) is the total direct and indirect costs incurred in accomplishing work on
an activity during a given period.

Example:
Suppose that it actually took two weeks and cost $20,000 to purchase and install the new Web
server. Assume that $15,000 of these actual costs was incurred during Week 1 and $5,000 was
incurred during Week 2. These amounts are the actual cost (AC) for the activity each week.

C. The Earned Value (EV) is an estimate of the value of the physical work actually completed.
EV is based on the original planned costs for the project or activity and the rate at which the
team is completing work on the project or activity to date. The rate of performance (RP) is the
ratio of actual work completed to the percentage of work planned to have been completed at any
given time during the life of the project or activity.

Example:
Suppose that the server installation was halfway completed by the end of Week 1. The rate of
performance would be 50 percent because, by the end of Week 1, the planned schedule reflects
that the task should be complete but only 50 percent of the work has been completed. In Table
4.2., the earned value estimate after one week is therefore $5,000.

Table 4.2:- Earned value calculations for one activity after Week 1
The earned value calculations above are carried out as follows:

The formulas above summarize the formulas used in earned value management. Note that the
formulas for variances and indexes start with EV, the earned value. Variances are calculated by
subtracting the actual cost or planned value from EV, and indexes are calculated by dividing EV
by the actual cost or planned value. After you total the EV, AC, and PV data for all activities on
a project, you can use the CPI and SPI to project how much it will cost and how long it will take
to finish the project based on performance to date. Given the budget at completion and original
time estimate, you can divide by the appropriate index to calculate the Estimate at Completion
(EAC) and estimated time to complete, assuming that performance remains the same. There are
no standard acronyms for the terms Estimated Time to Complete (ETTC) or Original Time
Estimate (OTE).

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 the cost variance is a
positive number, performing the work cost less than planned.

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 the work took less time than planned to perform.

The Cost Performance Index (CPI) is the ratio of earned value to actual cost; it can be used to
estimate the projected cost of completing the project. If the CPI is equal to one, or 100 percent,
then the planned and actual costs are equal – the costs are exactly as budgeted. If the CPI is less
than one or less than 100 percent, the project is over budget. If the CPI is greater than one or
more than 100 percent, the project is under budget.

The Schedule Performance Index (SPI) is the ratio of earned value to planned value; it can be
used to estimate the projected time to complete the project. Similar to the cost performance
index, an SPI of one, or 100 percent, means the project is on schedule. If the SPI is greater than
one or 100 percent, then the project is ahead of schedule. If the SPI is less than one or 100
percent, the project is behind schedule.

Note that in general, negative numbers for cost and schedule variance indicate problems in those
areas. Negative numbers mean the project is costing more than planned or taking longer than
planned. Likewise, a CPI and SPI of less than one or less than 100 percent also indicate
problems.
 The Cost Performance Index (CPI) can be used to calculate the estimate at completion
(EAC) – an estimated cost of completing a project based on performance to date. Similarly,
the schedule performance index (SPI) can be used to calculate an estimated time to complete
the project.
Budget at Completion (BAC) is the overall original total budget for the project. Example:
$100,000. The BAC point is plotted on the chart at the original time estimate of 12 months.
The earned value management is summarized in the following figure.

Figure 4.1:- Earned value chart for the project after five months
The Estimate at Completion (EAC) is estimated to be $122,308 in the figure above. This
number is calculated by taking the BAC, or $100,000 in this case, and dividing it by the CPI,
which was 81.761 percent. This EAC point is plotted on the chart at the estimated time to
complete 12.74 months. This number is calculated by taking the original time estimate, or 12
months in this case, and dividing it by the SPI, which in this example was 94.203 percent.

Software to Assist in Project Cost Management

 Spreadsheets
 Microsoft Project 2010