Budgeting and Cost Estimation

Introduction

Project Costs

One of the criteria of project success is completing the project within budget. Developing and controlling a project budget that will accomplish the project objectives is a critical project management skill. Although stakeholders expect the project to be executed effectively and efficiently, pressures to remain within budget vary based on the unique constraints and priorities of the project. On some projects, the project completion date is the highest priority leading to a more flexible budget to accommodate the inflexible deadline. Moreover, the project's scope may have to be scaled back if it is too ambitious to finish in time. On other projects, for example, ones with limited funding available, remaining within budget is the highest priority. When this is the case, effective cost management is imperative and trade-offs with scope, quality, and/or time may be required.

Boston's Infamous Big Dig (Central Artery/Tunnel) Project

One of the notorious examples of project budget overrun is Boston's Big Dig project although its outcome had significant benefits to the Boston residents by lowering traffic jams and pollution. Central Artery/Tunnel Project, the official name of the project, was the largest, most challenging highway project in the history of the United States. This project's objective was to reduce traffic and improve mobility in one of America's oldest, most congested major cities. Although the project had been planned in the 1980s, it was completed in 2007. Its original completion was scheduled in the late 1990s, and its original cost was estimated to be about 3 million dollars. However, including the interest to be paid, the total cost was estimated to be 24 million dollars. As listed by Greiman and Warburton (2009), common causes for cost escalation on the Big Dig included: the failure to include a cost for inflation in each contract; delays in project completion; and the actual rate of inflation being greater than the planned estimate. Other factors that impacted the Big Dig were financing shortfalls and interest rates, scope changes, shortages of materials and labor, price increases, and market changes, weak project managers, technical and design complexity, unexpected events and force majeure, and political and legal risks.

The Big Dig project is considered a mega project, and unfortunately, many mega projects suffered a substantial cost overrun as well as other problems regarding the scope, schedule, risks, and resources, which in turn, led to the cost overruns. However, smaller projects, even our personal projects such as moving to another house and going on a summer vacation, may experience problems with the cost. When problems start in a project, the sponsor, clients, and other stakeholders first realize the abnormality in the budget which is an explicit reflection of something going bad. The more money we spend over the estimated budget, the more it hurts the stakeholders since the financial assets of a project, organizations and individuals can be analogous to the blood of a living thing.

Some of the reasons why projects fail to keep themselves on track with regard to their budget can be outlined below:

1. Project activities may not be identified in accordance with the project objectives and product scope. For example, if the project manager doesn't include the required travel and accommodation expenses that are required for the factory test in another city or country.
2. The duration of project activities may not be estimated correctly, thus leading to shorter or longer duration. For example, if an activity's duration is determined as one week whereas it requires at least two weeks to complete all the tasks, an additional week would lead to more labor and material costs.
3. Underestimation of costs per activity and resource. Let's assume that the minimum hourly wage of a systems analyst is $30 currently, and it is difficult to find one who can accept a wage below $30. However, we take into account the costs in a similar project which was completed two years ago. Thus, we estimated $20 per hour for a systems analyst. If two analysts work for 100 hours in total, this underestimation could cause us to spend an additional $1,000 in the best scenario.
4. Risk identification is an essential process during the planning phase. If risks cannot be identified properly, for instance, if a risk that may put the project in jeopardy is overlooked, we will need to allocate an additional budget in case the risk occurs. In a worse case, the project may fail, which cannot be even saved with an additional budget.

Project Cost Types

There are generally three different types of project costs:

1. Direct costs
2. Project-induced overhead costs
3. General administrative costs

The primary difference between these costs is how closely related they are to the specific activities of the project.

Direct costs are directly related to specific project tasks. These costs represent the labor, time, and materials associated with specific tasks. If a software developer works on our m-commerce project for 40 hours, each hour they work to code the mobile application will be incurred as a direct cost. These are generally variable costs as is the case for the software developer cost.

Project-induced overhead costs are incurred as a result of the project's existence, but they are not directly related to specific tasks. These costs represent the compensation paid to individuals who are supporting the project in its entirety, such as the project leader and their support staff (project analysts, coordinators, etc.). These costs also represent materials, facilities, and related equipment that were purchased to support the project in general. The rental and maintenance of workspace for the project team members, as well as their computers and related information technology, supplies, and lunch (if provided), are all examples of overhead costs. If we rent an office for the developers and testers to work together, then this fixed cost would be also a direct cost.

Lastly, general administrative costs are indirectly related to a project, and they are incurred even if the project is not carried out. Examples of this type of cost include marketing, human resources, and accounting department-related expenses. These departments may provide ad-hoc and minimal support to the project teams and as a result, the project sponsors may want a portion of their costs to be allocated to all projects underway in the organization. Allocating a portion of the costs to the project provides the executive with a full picture of all costs incurred due to the implementation of strategic change initiatives in the organization. Since the allocation methods are often very subjective, many organizations exclude general administrative costs from the project budget.

It is important to note that some projects require the direct involvement of these administrative functions. This should be clearly identified in the project's work breakdown structure. For instance, a project that involves the introduction of new technology will alter the way people work and this may require members of the human resources department to reevaluate existing job descriptions, compensation levels, and so forth.  In this instance, the human resources function is a work package and the costs associated with their work are direct costs.

Source: Abdullah Oguz, https://pressbooks.ulib.csuohio.edu/project-management-navigating-the-complexity/chapter/9-1-project-costs/
This work is licensed under a Creative Commons Attribution 4.0 License.

Project Cost Management Plan

As described, project planning is at the heart of the project life cycle and tells everyone involved where we are going and how we are going to get there. It involves creating a set of plans to help guide our team through the implementation and closure phases of the project. The project cost management plan is one of the sub-plans of our overall project plan. It provides guidelines to project managers on how to estimate, budget, manage, monitor, and control project costs.

A project cost management plan consists of similar items that we have in a schedule management plan. This plan can consist of the following:

• Process descriptions
  
  • What processes will be used for cost management?
  • These processes include planning, estimating costs, and establishing the overall budget.
• Unit of measurement
  
  • Daily working hours and shifts for human resources and equipment
  • Weekends and/or off-days for especially human resources
  • Metric (e.g., meter, liter, kilogram) or imperial (e.g., inch, gallon, pound) system measurement units
• Level of accuracy
  
  • Acceptable range to ensure realistic cost estimates (e.g., ±10%, ±20)
  • Evaluation of the impact of risks on the costs of each activity and overall project based on the project risk management plan
  • Methods describing how the cost contingencies will be assessed.
  • Procedure to account for fluctuations in currency exchange rates
• Level of precision
  
  • The degree to which cost estimates will be rounded up or down (e.g., $95.55 to $96; $95.45 to $95; $495.75 to $496 or $500)
  • Evaluated based on the scope, size, and complexity of the project.
• Cost estimation methods
  
  • Estimation methods (e.g., expert judgment, analogous, parametric, three-point, bottom-up), and when they will be utilized.
• Methods, tools, and software utilized to develop, manage, and monitor project cost
  
  • Specify the organizational procedures and policies if they should be utilized.
  • Methods and tools such as control accounts, WBS, project baseline, Earned Value Management, and critical path method
  • Reserve analysis to set aside some money for cost overruns due to risks in order to implement risk mitigation strategies.
  • Software such as Microsoft Project Professional, Excel, Visio, and Jira (for Kanban and Scrum), and online collaboration tools such as Monday, Trello, and Basecamp.
• Rules for monitoring cost performance
  
  • Earned Value Management (EVM)
  • Defining the points in the WBS at which measurement of control accounts will be performed
  • How strategic funding choices would be managed.
  • Control thresholds for deviations from the parameters in the cost baseline
  • Using software such as Microsoft Project
• Reporting formats
  
  • Reporting formats and frequency should be in alignment with other project plans.
  • When, how frequently, and to whom are we reporting?
• Approval of the cost baseline
  
  • Who will be responsible for preparation and control?
  • Who will approve the cost baseline?

Estimating Costs and Determining Budget

Establishing the Project Budget

Once the cost of each activity is estimated, it is possible to determine how much money is needed for each activity and component, and the whole project. The process of subtotaling costs by category or activity is called cost aggregation. PMBOK Guide Sixth Edition defines this process as "Determine Budget" which is a process of aggregating the estimated costs of individual activities or work packages to establish an authorized cost baseline. This baseline is a time-phased budget that can be used to measure and monitor cost performance after it has been approved by the key project stakeholders. The aggregated budget is integrated with the project schedule in order to produce the time-phased budget. Costs are associated with tasks, and since each task has a start date and a duration period, it is possible to calculate how much money will be spent by any particular date during the project. Recognizing that all the money required to deliver the project is not needed upfront, allows the cash flow needs of the project to be effectively managed. For smaller organizations facing cash flow challenges, this can result in significant savings as the money required to pay for resources can be transferred to the project account shortly before it is needed.

Figure 9.1 illustrates the project budget components. While estimating the costs, the project team should take into account the uncertainties that may affect the costs. This requires a reserve analysis which is conducted in line with risk management. Therefore, cost estimates are accompanied by contingency reserves for each activity and work package, if applicable. As can be seen in Figure 9.1, contingency reserve is included within the cost baseline. Therefore, these reserves must be incorporated into the baseline that ensures the monitoring and controlling of the project cost performance.

Let's elaborate more on the reserve analysis. Contingency reserves are determined according to the risks that can be identified by the project team. Thus, they are called "known-unknowns". In our m-commerce project, our team identified a risk regarding the shortage of software developers. The demand for developers increased recently since the demand for online games and mobile apps has been on a sharp rise after the emergence of the COVID-19 pandemic. Therefore, we may experience a shortage of developers in the market. This risk can directly affect the activities under "2. Analysis/App Requirements" and "4. Development". Therefore, it would be appropriate to allocate contingency reserves to each affected activity. Unlike contingency reserve, management reserve is determined based on "unknown-unknowns" and applies to the whole budget. One obvious risk that emerged at the end of 2019 and has had a severe impact on all countries since March 2020 is the COVID-19 pandemic. This pandemic was an unknown-unknown for all the projects across the world.

The amount of a contingency reserve for each activity or a higher WBS level is determined after the risks and the strategies are identified and detailed. For instance, if an activity to test a website's functions and security is estimated to cost $10,000, the project team can put an additional budget of $2,000 to ensure an effective response to the security gaps if occurs. Then, the cost baseline of this activity becomes $12,000 ($10,000 + $2,000). It can be adjusted when more information becomes available as time passes and activities are conducted and completed. It is also possible that new risks may emerge which has not been forecasted while the project management plans were being prepared. This is why project teams have regular meetings at which all the project components, issues, and risks are reviewed, which allows the team to take timely actions.

If we turn back to Table 9.3, we can see that the contingency reserves are not determined, therefore, the cost baseline includes only the resource costs. Let's assume that the project team agreed on contingency reserves for three activities as shown in Table 9.5. Therefore, the cost baseline increases from $23,920 to $24,920.

Managing Project Costs

A key aspect of ongoing cost management is monitoring cost estimates. Projects seldom go according to plan in every detail. Baseline budgets often change after they have been approved. Successful project leaders understand that estimates are just that, estimates. As new information and real experience occur, it may be necessary to revise an estimate. In some cases, the revision is minor and does not impact the achievement of the project's total budget. In other instances, the necessary revisions are significant, and a new baseline needs to be created. Project managers need to discuss the ongoing management of the schedule with key stakeholders to understand their expectations of when/how they are informed of changes that need to be made. Stakeholders' expectations for ongoing cost management can be documented in the Cost Management Plan.

The project manager must be able to identify when costs are varying from the budget and, thus, manage these variations. 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 understanding of how this progress will be measured and reported.  Earned Value Management (EVM) is an effective tool used by project managers to monitor and control these variations.

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 on other investments until the last moment before transferring 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 project manager would like to have as much cash available as possible to use if activities exceed budget expectations.

As explained, project managers keep contingency and management reserves in case risks occur and activities need more money. In practice, most projects face uncertainties that increase costs above the original estimates. Estimating the likelihood of such uncertainties is part of risk analysis.

Project Procurement Management

The procurement effort on projects varies widely and depends on the type of project. The "procurement cycle" reflects all procurement-related activities from when the decision is made to outsource equipment through to the payment of bills and closing of procurement contracts.

In less complex projects, the project team performs the work associated with procurement management. The procurement cycle includes:

• Identifying the required materials, equipment, and supplies
• Identifying the potential vendors
• Preparing requests for quotes (RFQs) and requests for proposals (RFPs), which include product/service specifications and a detailed delivery schedule
• Evaluating RFQs and RFPs to select the most suitable vendors
• Awarding and signing contracts
• Administering the contract and monitoring vendors' performance
• Managing contract changes
• Closing out the contract upon work completion

On more complex projects, procurement professionals may be assigned to assist the team throughout the project's lifetime.

Procurement Management Plan

In order to manage the process effectively and efficiently, we need to plan as we did for all the other knowledge areas (i.e., scope, schedule, cost, stakeholders, communication, resources). Therefore, we need to prepare a procurement management plan to document project procurement decisions, specify the approach, and identify potential sellers. We need to think about all of the work that we will contract out before doing anything else. We will want to plan for any purchases and acquisitions. Here's where we take a close look at our needs, to be sure that we need to create a contract. Therefore, we should figure out what kinds of contracts make sense for our project, and we try to define all of the parts of our project that will be contracted out. We work out how we manage contracts, what metrics contracts should meet to be considered successful, how we will pick a seller, and how we will administer the contract once the work is happening.

The procurement management plan details how the procurement process will be managed. It can include the following information:

• Roles and responsibilities of the project team and procurement professionals
• The types of contracts we plan to use, and any metrics that will be used to measure the contractor's performance.
• The planned delivery dates for the work or products we are contracting.
• The organization's standard procurement documents and processes that our project must use and comply with.
• How many vendors or contractors are involved and how they will be managed.
• How purchasing may impact the constraints and assumptions of the project plan.
• Coordination of purchasing lead times with the development of the project schedule.
• Identification of prequalified sellers (if known).

The procurement management plan like all other management plans becomes a subsidiary of the project management plan. Some tools and techniques we may use during the procurement planning stage include make or buy analysis and defining the contract type.

Make or Buy Analysis

This means figuring out whether or not we should be contracting the work or doing it ourselves. It could also mean deciding whether to build a solution for the organization's or client's needs or buy one that is already available in the market. Most of the same factors that help us make every other major project decision will help us with this one. How much does it cost to build it as opposed to buy it? How will this decision affect the scope of the project? How about the project schedule? Do we have time to do the work and still meet our commitments? As we plan out what we will and won't contract, we need to have thought through our reasoning pretty carefully.

There are some resources (like heavy equipment) that our company can buy, rent, or lease depending on the situation. We need to examine leasing versus buying costs and determine the best way to go forward.

Contract Types

We should know a little bit about the major kinds of contracts so that we choose the one that creates the fairest and most workable deal for us and the contractor. Some contracts are fixed price. No matter how much time or effort goes into them, we always pay the same (Figure 9.2). The cost (or revenue to the vendor) is constant regardless of the effort applied or the delivery date. Some contracts are cost reimbursable also called cost plus (Figure 9.3). This is where the seller charges us for the cost of doing the work plus some fee or rate. In a cost reimbursable or cost-plus contract, the seller is guaranteed a specific fee. The third major kind of contract is time and materials (Figure 9.4). That's where the buyer pays a rate for the time spent working on the project and also pays for all the materials used to do the work. In a time and materials contract, the cost (or revenue to the vendor) increases with increased effort.

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 completion is the same as that used for cost budgeting. For example, if a graphic designer is putting together several pieces of artwork for a textbook, their contract may call for partial payment after 25% of their total number of drawings is complete.

Project Software

These images use Microsoft Project software; however, most project software will have the same capabilities.

Let's continue with our example of the project for developing a mobile application. Here, we are building upon the Chapter 8 tutorial. Therefore, we are working on "1. Scope" (Table 9.6). This table also includes the duration, start and finish dates, and predecessors.

We identified the resources. Now, in the Resource Sheet, we can type the standard rates of resources (Figure 8.8).

In the Resource Sheet, there are three types of resources:

1. Work: Work resources are people and equipment. They have a standard rate per hour.
2. Material: Material resources are consumable supplies. They have a unit of measurement such as tones, boxes, and cubic yards.
3. Cost: Cost resources are independent costs we want to associate with a task such as a plane ticket.

In Table 9.5 (Section 9.4), we determined contingency reserves for three activities. As seen in Figure 9.5 above, contingency reserves were indicated as a "Cost" type which is independent of hourly work.  For activity 1.1, let's double-click on the activity row. The "Task Information" window will pop up. Then, let's click the "Resources" tab. For the work type resources (i.e., Sales and Marketing Experts and Systems Analysts), the cost is calculated automatically based on the hours worked. For the cost type, we must type the cost on this window. For activity 1.1, the contingency reserve is $300 (Figure 9.6).

 

When we finish typing the contingency reserves for the other two activities, the Gantt Chart will be as in Figure 9.7.

In this tutorial, we ignore the project manager's salary. As seen in Figure 9.8, we can insert a new column "Cost" to the left of Resource Names, and therefore, we can directly see the cost per activity on the main window (Gantt Chart view).

Key Takeaways

• Allocation of resources provides the project manager to determine the overall project budget most of which is spent on resources.
• Three types of project costs are direct costs, direct overhead costs, and general administrative costs.
• The project cost management plan is one of the sub-plans of our overall project plan, and it provides guidelines to project managers on how to estimate, budget, manage, monitor, and control project costs.
• The techniques to estimate costs are expert judgment, analogous estimating, parametric estimating, three-point estimating, and bottom-up estimating. Generally, project managers utilize some of the techniques together to estimate the activity costs.
• The process of subtotaling costs by category or activity is called cost aggregation. This process leads to the establishment of a cost baseline which is a time-phased budget that can be used to measure and monitor cost performance after it has been approved by the key project stakeholders.
• Funds allocated to deal with known-unknowns are called contingency reserves. The monetary amount of contingency reserves is determined after the risks and the strategies to mitigate risks' impact are identified and detailed.
• Projects seldom go according to plan in every detail. Baseline budgets often change after they have been approved.
• A project procurement management plan documents project procurement decisions, specify the approach, and identify potential sellers.
• Project teams should figure out whether to build a solution for the organization's or client's needs or buy one that is already available in the market.
• The most common contract types are fixed-price, cost reimbursable or cost plus, and time and materials contracts.