Project Cost Management
Cost management is an important area of responsibility for project managers. The cost management work often includes estimating, budgeting, and controlling costs through the project.
If you are preparing for your PMP exam, here are a few of the points related to project cost management that you should be sure to understand (this is not all-inclusive):
- Some environmental factors that may impact your project’s cost estimate and cost tracking include cost account codes and other accounting system components, control thresholds, reporting formats, earned value rules, and internal processes.
- Common types of cost estimates: parametric, analogous, bottom-up, and apportioning. Apportioning is not always considered a major estimating category.
- There are two types of Costs of Quality Considerations: 1) Cost of Conformance (prevention costs and appraisal costs), and 2) Cost of Non Conformance (internal failure and external failure).
- Life Cycle costing: All project and product costs are included from the conception to the retirement of the product.
- Net present value (NPV): The sum of the present value minus the initial investment. If NPV is greater than or equal to zero the project is often considered acceptable. Bigger is better.
- Internal Rate of Return (IRR): The IRR generally must meet a predetermined rate as part of the project selection criteria. It is expressed as a percentage rate of return based on the project costs. Bigger is better.
- Payback period: How long will it take to recover the project cost investment. This generally does not consider the time value of money. Shorter payback periods are better.
- Benefit cost ratio (BCR): A ratio of benefits to costs. Ratio of greater than 1 means benefits are greater than the costs.
- Break even analysis: The point in time at which income returned equals the project costs.
- Sunk costs: The concept to remember here is that this cost is not recoverable and sunk costs are not to be considered when going forward with a project.
- Opportunity costs: When you focus on Project A, it generally means that resources are not available to work on Project B. The lost value of Project B is Project A’s opportunity cost. The smaller the better.
- Indirect costs versus direct costs. Direct costs are labor, materials, and other expenses associated to the project. Indirect costs are oftentimes called overhead and they do not vary based on the project. Examples of indirect costs include building rent, administrative costs, electric power, and general operational fees.
For the PMP Exam you may need to know about straight-line depreciation and the double-declining-balance method. Straight-line is simple: You depreciate the same percentage every year based on the book life of the asset. So we depreciate 10% every year for a 10-year life-span. If it were a 20-year life-span we would depreciate 5% (100%/5 years) per year.
In the double-declining-balance method you depreciate double this percentage from the balance of the asset. In an asset that had a book life of 10 years, we would depreciate 20% every year from the balance. So in an asset that had a value of $500,000 the first year we would depreciate 20% of $500,000. That is a $100,000 depreciation, and we have $400,000 left. In the second year, we would depreciate 20% of the balance of 400,000. That would be $80,000 and we are left with a balance of $320,000.
Estimate at Complete versus Budget at Complete
To-Complete Performance Index (TCPI)
The TCPI is a index much like the CPI (Cost Performance Index). However CPI is historic information relative to your project performance to-date. The TCPI is usually a calculation that is determined when a project has been running over budget, and you need to determine the minimum index level that you must perform at through the remainder of the project, if you are to finish within budget. So it is a forecast of a spending efficiency that must be obtained in comparison to the baseline plan.
It is used in conjunction with Earned Value. Calculating the TCPI is a good planning forecast when the rest of the project will be very similar to the past portion of the project, using the same type of work and similar resources.
The formula for TCPI is the “value of the work remaining” divided by the “funds remaining”. More specifically this formula is (BAC-EV)/BAC-AC).
Estimating Time and Cost
Here is a very brief summary of the most important estimating best practices:
Compare actuals to estimates. After the work has been done, compare the actual time the work took to the original estimate. Track the percent off (either under or over) and report that information back to the team members. The best way to improve estimating accuracy is by paying attention. The best way to pay attention is by tracking metrics.
Use more than one approach or more than one person, or both. After you have one estimate, compare the logic using either another approach or another person’s perspective.
Clearly write out what makes this work complete. Many times there are unknown needed revisions, quality acceptance criteria, and a level of completeness that has not been clearly thought out, not to mention communicated to the person doing the estimating.
Present estimates in either a range or by indicating your level of confidence. For example, our project team estimates this will cost $100,000, and we have a confidence level of -20% to +60% (meaning it could very possibly fall between $80,000 and $160,000).
Understand the definition of an estimate. In many knowledge projects (such as engineering, research, IT, creative, etc) the time work takes to create unique deliverables can be extremely difficult to accurately estimate. And eventually the estimation discussion turns into a risk tolerance question. It generally needs to be agreed that without seriously inflating estimates to turn them into guarantees, that schedules are best planned with some flexibility and contingency for going over. There are diminishing returns in over-analyzing the project.
Ask SMEs. Subject matter experts (SMEs) can be a big help, especially in informing project managers what the commonly overlooked work or costs are. There are very common estimation omissions. You will benefit from questioning what they are.
Types of Reserves
There are two types of budget reserves: contingency and management.
Contingency reserves are allowances for unplanned but potentially required changes that can result from realized risks identified in the risk register.
Management reserves, on the other hand, are budgets reserved for unplanned changes to project scope and cost.
The PM may be required to obtain approval before obligating or spending the management reserve, but generally this approval is not needed from the sponsor for the contingency reserve.
Management reserves are not part of the project cost baseline, but they may be included in the total budget for the project. Contingency reserves are ideally included in the cost baseline and budget.
Net Present Value
To determine the NPI, calculate the present value of cash flows for each year of the project. The present values are summed up and then the initial investment is subtracted from the sum.
Reserve analysis is the process of determining if sufficient reserves/contingencies have been included in the budget estimating and planning.
Successful Projects didn’t create this idea. A student told about this tip for the PMP exam dump sheet. She didn’t remember exactly where she read it, but after searching a while, we think the idea may have originated from the follks at Global Associates (www.globalassociates.com) because it’s listed on their web site – but were not entirely sure. But here’s the gist of the tip:
Start writing down your Earned Value formulas by putting these things in a vertical column on your sheet:
Then add the equals sign to each row, so it looks like this:
Then add the EV part of the equation to each row, so it looks like this:
Then in the last step you have to remember a bit about what each thing is, but the previous steps got the logic all set up for you to complete the formulas based on what the relative information is. There are two divide formulas and two subtraction formulas. The indexes use the divide formulas. That goes as follows:
Mean, Median & Mode
Mean: The average.
Median: Sort the values from smallest to largest. If there is an even number of values, the median is the average of the two middle numbers. If there is an odd number of values, the median is the one in the middle of the pack.
Mode: The value that occurs most often.
And another term that often is used along with these is standard deviation, which is represented by the symbol σ and it basically shows how much variation there is from the mean.
Fully Burdened Rates
Estimates are supposed to be provided at “fully burdened rates” – meaning they include overhead costs. This is also called fully loaded rates.
The minimum return rate for a project that an organzation sets for consideration of new projects.
Don’t Need a Budget?
If your project is the type that doesn’t require a budget or it’s not expected by the stakeholders?
Do it anyway!
Develop a project budget because it helps make sure you’re all on the same page, it enables you to recognize project performance issues sooner, and it better prepares you for risk management and the questions are going to pop up later.