Unit-IV

Cost Estimating and

Budgeting
 The Importance of Project Cost Management
2
 When it comes to cost control in project management, it can be challenging to forecast
and manage project costs effectively.

 In fact, there is news every day about construction projects going over budget and
time, yet this is avoidable with strong cost management.

 “Project cost management” sets the baseline for “project costs”.

 Effective cost management ensures that a project’s budget is on track and will be
completed according to its planned scope.

 Without cost control, a company can easily lose money and costs can go above
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project profit.
 The Importance of Project Cost Management
3
 The process of managing project cost can be carried out in 3 steps.

 The first is estimating and planning cost, followed by

 developing a project budget, and finally,

 controlling spending and tracking costs in real time to make sure there are
no unexpected changes.

 Ideally, cost estimates are based upon elements of the Work Breakdown
Structures (WBS) and are prepared at the “work package level”.

 When the cost cannot be estimated because of uncertainties about the

work, the initial estimate is based upon judgement and later revised as 3/3/2022

information becomes available.

 What is Cost and Project Cost Management?
4

 Cost is a resource sacrificed to achieve a specific objective.

or

 Cost is something given up in exchange.

 Costs are usually measured in monetary units like dollars, INR, etc.

 Project cost management includes the processes required to ensure that the
project is completed within an “approved budget”.

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 Project Cost Management Processes
5

 Resource Planning: Determining what resources and quantities of them should

be used.

 Cost Estimating: Developing an estimate of the costs and resources needed to

complete a project.

 Cost Budgeting: Allocating the overall cost estimate to individual work items to
establish a baseline for measuring performance.

 Cost Control: Controlling changes to the project budget.

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 Basic Principles of Cost Management
6

 Most CEOs and boards know a lot more about finance than IT, so IT project
managers must speak their language

1. Profits are revenues minus expenses

2. Life cycle costing is estimating the cost of a project plus the maintenance costs
of the products it produces

3. Cash flow analysis is determining the estimated annual costs and benefits for a
project

4. Benefits and costs can be tangible or intangible, direct or indirect

5. Sunk cost should not be a criteria in project selection

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 Basic Principles of Cost Management
7
 Tangible costs or benefits are those costs or benefits that an organization can
easily measure in dollars, INR, etc.

 Intangible costs or benefits are costs or benefits that are difficult to measure in
monetary terms.

 Direct costs are costs that can be directly related to producing the products and
services of the project.

 Indirect costs are costs that are not directly related to the products or services of
the project, but are indirectly related to performing the project.

 Sunk cost is money that has been spent in the past; when deciding what projects
to invest in or continue, you should not include sunk costs.
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 Basic Principles of Cost Management
8
 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.

 Reserves; are dollars or INR included in a cost estimate to mitigate cost risk by
allowing for future situations that are difficult to predict.

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

2. Management reserves allow for future situations that are unpredictable

(sometimes called known unknowns).

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 Project Cost Management Processes
9

 Resource Planning: Determining what resources and quantities of them should

be used.

 Cost Estimating: Developing an estimate of the costs and resources needed to

complete a project.

 Cost Budgeting: Allocating the overall cost estimate to individual work items to
establish a baseline for measuring performance.

 Cost Control: Controlling changes to the project budget.

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 Resource Planning
10
 The nature of the project and the organization will affect resource planning

 Some questions to consider:

1. How difficult will it be to do specific tasks on the project?

2. Is there anything unique in this project’s scope statement that will affect
resources?

3. What is the organization’s history in doing similar tasks?

4. Does the organization have or can they acquire the people, equipment, and
materials that are capable and available for performing the work?

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 Project Cost Management Processes
11

 Resource Planning: Determining what resources and quantities of them should

be used.

 Cost Estimating: Developing an estimate of the costs and resources needed to

complete a project.

 Cost Budgeting: Allocating the overall cost estimate to individual work items to
establish a baseline for measuring performance.

 Cost Control: Controlling changes to the project budget.

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 Cost Estimating
12
 An important output of project cost management is a cost estimate.

 Cost estimation is the iterative process of developing an approximation of the

monetary resources needed to complete project activities.

 There are several types of cost estimates and tools and techniques to help create
them

 It is also important to develop a cost management plan that describes how cost
variances will be managed on the project

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 Cost Estimating
13
 Project teams should estimate costs for all resources that will be charged to the project.

 This includes but is not limited to:

 Labor

 Materials

 Equipment

 Services

 Software

 Hardware
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 Facilities and Contingency Costs

 Types of Cost Estimates
14
Type of Estimate When Done Why Done How Accurate
Rough Order of Very early in Provides rough –25%, +75%
Magnitude the project life ballpark of cost
(ROM) cycle, often 3– for selection
5 years before decisions
project
completion
Budgetary Early, 1–2 Puts dollars or –10%, +25%
years out inr in the budget
plans
Definitive Later in the Provides details –5%, +10%
project, < 1 for purchases,
year out estimate actual
costs
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 Cost Estimation Tools and Techniques
15
 The following list includes common tools and techniques used in project cost
estimation::

 Expert Judgment – Use of knowledge gained from past project management

experience. Expert judgment, in conjunction with objective estimation techniques,
provides valuable information about the organizational environment and information
from prior comparable projects.

 Analogous Estimating – Use of the metrics from a previous, similar project as the basis
of estimation for the current project. Analogous estimating takes the actual cost of
previous, similar projects as a baseline and then adjusts for known differences (such as
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size, complexity, scope, duration, etc.).
 Cost Estimation Tools and Techniques
16

 Parametric Estimating – Use of a statistical relationship between historical data and

other variables (for example, lines of code in software development) to calculate an
estimate for activity parameters, such as scope, cost, budget, and duration. Used
correctly, this technique can produce high levels of accuracy.

 Bottom-Up Estimating – Estimating all individual work packages/activities with the

greatest level of detail, summarizing higher-level estimates with the combination of the
individual estimates. The accuracy of bottom-up estimating is optimized when individual
work packages/activities are defined in detail.

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 Cost Estimation Tools and Techniques
17
 Three-Point Estimates – Use of three estimates to determine a range for an activity’s cost;
the best-case estimate, the most likely estimate, and the worst-case estimate.

 Reserve Analysis – Determination of contingency reserves to account for cost uncertainty.

 Project Management Estimating Software – Use of project management cost estimating

software applications, computerized spreadsheets, simulation, and statistical tools. Such
tools can allow for rapid consideration of multiple cost estimate alternatives.

 Vendor Bid Analysis – Determination of what the project should cost based on a review of
vendor bids/proposals. This technique may be used in conjunction with other cost
estimation techniques to ensure that cost estimates are comprehensive. 3/3/2022
 Cost Management Plan
18

 A cost management plan is a document that describes how the organization will
manage cost variances on the project.

 A large percentage of total project costs are often labor costs, so project managers
must develop and track estimates for labor.

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 Typical Problems with IT Cost Estimates
19
 Developing an estimate for a large software project is a complex task requiring a
significant amount of effort. Remember that estimates are done at various stages of
the project

 Many people doing estimates have little experience doing them. Try to provide
training and mentoring.

 People have a bias toward underestimation. Review estimates and ask important
questions to make sure estimates are not biased

 Management wants a number for a bid, not a real estimate. Project managers must
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negotiate with project sponsors to create realistic cost estimates.
 Surveyor Pro Project Cost Estimate
20

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 Cost Budgeting
21
 The budget serves as a standard for comparison.

 Cost budgeting involves allocating the project cost estimate to individual work items
and providing a cost baseline.

 It is a baseline from which to measure the difference between the actual and planned
use of resources.

 Budgeting procedures must associate resource use with the achievement of

organizational goals or the planning/control process becomes useless.

 The budget is simply the project plan in another form. 3/3/2022

 Cost Budgeting
22
 In order to develop a budget, we must:

 Forecast what resources the project will require

 Determine the required quantity of each

 Decide when they will be needed

 Understand how much they will cost - including the effects of potential price
inflation

 There are two fundamentally different strategies for data gathering:

 Top-down

 Bottom-up
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 Top-Down Budgeting
23  This strategy is based on collecting the judgment and experiences of top and middle
managers.

 These cost estimates are then given to lower level managers, who are expected to
continue the breakdown into budget estimates.

 This process continues to the lowest level.

 Advantages:

 Aggregate budgets can often be developed quite accurately

 Budgets are stable as a percent of total allocation.

 The statistical distribution is also stable, making for high predictability.

 Small yet costly tasks do not need to be individually identified.

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 The experience and judgment of the executive accounts for small but important tasks to be factored
into the overall estimate.
 Bottom-Up Budgeting
24  In this method, elemental tasks, their schedules, and their individual budgets are
constructed following the WBS or project action plan

 The people doing the work are consulted regarding times and budgets for the tasks to
ensure the best level of accuracy

 Initially, estimates are made in terms of resources, such as labor hours and materials

 Bottom-up budgets should be and usually are, more accurate in the detailed tasks, but
it is critical that all elements be included

 Advantages:

 Individuals closer to the work are apt to have a more accurate idea of resource requirements

 The direct involvement of low-level managers in budget preparation increases the likelihood that they
will accept the result with a minimum of aversion
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 Involvement is a good managerial training technique, giving junior managers valuable experience
 Elements of Budgets and Estimates
25

 Budgets and estimates are similar in that both state the cost of doing something.

 The difference is that the estimate comes first and is the basis for the budget.

 An estimate may have to be refined many times, but once approved it becomes the
budget.

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 Elements of Budgets and Estimates
26

 Estimates and budgets share most or all of the following elements:

1. Direct labour expense

2. Direct non-labour expense

3. Overhead expense

4. General and administrative expense

5. Profit and total billing

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 Elements of Budgets and Estimates
27

Direct labor expense

 Direct labour expense is the charge of labour for the project.

 For each task or work package, an estimate is made as to the number of people needed
in each labor grade, and the number of hours or days for each.

 This gives the distribution of labour hours or days required for each labour grade.

 The labor hours for the various grades are then multiplied by their respective wage
rates.
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 Elements of Budgets and Estimates
28 Direct labor expense

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 Elements of Budgets and Estimates
29 Direct non-labour expense-

It is the total expense of non-labour charges applied directly to the task. It includes :

1. Subcontractors

2. Consultants

3. Travel

4. Telephone

5. Computer Time

6. Material Costs

7. Purchased parts and Freight

Also referred as “other direct cost”

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 Elements of Budgets and Estimates
30 Overhead, General and Administrative Expenses

Although direct expenses for labour and materials are easily charged to a specific work
package, many expenses cannot be so easily be allocated to specific work packages, nor
even to specific projects.

These expenses, termed overhead or non-direct expenses, are the cost of doing
business.

They include building rents, clerical assistance, insurance etc.

Usually overhead is computed as percentage of direct labour cost.

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 Elements of Budgets and Estimates
31 Overhead Expenses

The overhead rate is computed by estimating the annual business overhead expense, then
dividing by the projected total direct labour cost for the year.

Suppose projections show that total overhead for next year will be Rs. 1,80,000.

If total anticipated direct labour charges will Rs.1,50,000, then the overhead rate to
apply is 180000/150000 = 1.20.

Thus, for every Re.1 charged to direct labour, Rs.1.20 is charged to overhead.

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 Elements of Budgets and Estimates
32 Overhead Expenses

Although this is the traditional accounting method for deriving the overhead rate, for
project management it results in an arbitrary allocation of costs, which is
counterproductive for controlling project costs because most sources of overhead costs
are not tied to any particular project.

A better way is to divide overhead costs into two categories: direct overhead, which are
costs that can be allocated in a logical manner; and indirect overhead (G&A), which
cannot.

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 Elements of Budgets and Estimates
33
General and Administrative Expenses

G&A includes taxes, financing, penalty, warranty costs, accounting and legal support,
proposal expense on lost contracts, marketing and promotion, salaries and expenses of
top management, employee benefits.

These costs might not be tied to any specific project or work package, so they are
allocated across all projects, to certain projects, or parts of projects.

Often, G&A overhead is charged on a time basis, hence the longer the duration of the
project, the greater the G&A expense for the project.
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 Elements of Budgets and Estimates
34
Profit and Total Billing

Profit is the amount left over for the contractor after expenses have been subtracted from
the contractual price.

It is an agreed-to fixed fee or a percentage of total expenses.

Total billing is the sum of total expenses and profit.

Profit and total billing are included for estimates of the project as a whole, for large
groups of work packages, and for subcontracted work.

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They usually do not appear on budgets for lower-level work elements.