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Monday, June 20, 2011

Chapter 43: Estimating Costs and Determining Budgets

In the previous chapter we learnt how to create the project human resource plan. To get resources you need to spend money (Cost) and you cant spend an infinite amount. Every project has certain limits on the amount of money you can spend (Budget). In this chapter, we are going to learn about estimating the costs and determining the budget involved in a project.

So, lets get started!!!

Difference Between Cost & Budget:

Many people confuse the terms cost & budget and even use them interchangeably. Unfortunately they are both not the same. So, the first thing we need to do is, understand clearly the difference between cost and budget.

Cost is the value of the inputs that have been (or will be) used up to perform a task or to produce an item: product, service, or result. This value is usually measured in units of money. For example, you paid two programmers Rs. 5000/- each for developing a software program, and you paid Rs.1000/- to a tester to test the program. So, the cost for the task of developing and testing the software program is Rs. 11,000/-. You can add the costs of components of a system, and the sum will represent the cost of the system, but it’s still a cost and not a budget.
Budget is an aggregated cost with a timeline. You aggregate the costs of all the resources needed to perform the project and put a timeline on it: the availability of funds over time. That is called a budget.

Look at the image below:


Cost management consists of estimating project costs, determining budget from the cost estimates, and controlling the cost while the project is being executed. This is just a high level depiction of cost management and we will cover the details now.

Estimating Project Costs

Estimating project cost means developing an estimate for the monetary resources needed to complete the project work; that is, activities. These estimates are based on the information available at a given time. The estimates in the beginning are less accurate; for example, their accuracy may be only as good as + or - 50 percent. For example, if you say the cost will be $50,000, it could be anywhere between $25,000 and $75,000. As the project moves along and more information becomes available, the cost estimates can be improved to get better estimates.
The standard process used to estimate costs is called the Estimate Costs process. Look at the image below:



Estimating project cost means estimating the costs required to complete the project scope by executing schedule activities. Therefore, you need the scope baseline and the schedule baseline for estimating costs. Recall that the scope baseline is constituted by the scope statement, the WBS, and the WBS dictionary, and the schedule baseline is the approved project schedule. The list of items used as input to this process are:
• Human resource plan - The information in the human resource plan useful for estimating costs includes the list of roles and responsibilities, personnel rates, and recognitions and rewards.
• Project schedule - An approved project schedule will give you the information about the resources needed to complete the project work. This information is crucial to make cost estimates. As you learned in the previous chapter, activity resources are estimated by performing the Estimate Activity Resources process. Therefore, the Estimate Costs process should be closely coordinated with the Estimate Activity Resources process, which in turn depends on the Estimate Activity Durations process because activity duration is determined for the given resources.
• Scope baseline - All three components of the scope baseline; scope statement, WBS, and WBS dictionary are useful in estimating the project cost. The scope statement will provide the cost-relevant information, such as project and product acceptance criteria, assumptions and constraints, product description, key deliverables, and project boundaries around the scope.
• Risk register - Both kinds of risks—threats and opportunities have an impact on the cost in the form of risk mitigation costs and revenues or savings from the opportunities.
• Enterprise environmental factors - Enterprise environmental factors relevant to estimating costs include market conditions and published commercial information that will provide the cost of resources, including human resources, materials, and equipment. This will also provide the information related to the availability of products and services and their cost and rates. Supply and demand conditions can also influence the project cost.
• Organizational process assets - This includes the organization’s policies regarding cost estimates, cost estimating templates, and information from previous projects, including lessons learned.

Tools & Techniques used in Cost Estimating

Some tools and techniques that can be used in cost estimating and budgeting are:
Analogous estimation - Analogous cost estimation is a technique that uses cost-related variables, such as rate, cost of a component, cost of an activity from similar tasks and activities in previous projects, or cost of a similar project from the past, to measure the same variable in the current project. This technique is useful when very limited component information is available, especially in the beginning of a project, and is usually used for estimating the gross values and not the detailed component-based values. It’s generally less costly and less time consuming than other techniques, but it also is less accurate. Its accuracy and reliability improve if the person making the estimate is an expert and the components or activities being compared are actually similar.

Parametric estimation - This is a technique that uses some parameters and statistical relationships among them to make the estimate. For example, if the unit cost is known, say from historical data, the cost of the whole package containing a number of units can be calculated. This technique can generate quite accurate results depending on the accuracy of the quantity of resources and other data that goes into the estimation.

Bottom-up estimation - This technique involves estimating the cost of the parts of a component and then aggregating the cost of those parts to calculate the cost of the whole component. This technique can generate accurate results when you can generally make a better estimate of a part than the whole, which is usually the case when enough information is available.

Contingency reserve analysis - The following two problems are associated with the estimates:
• Estimates are approximations, and approximations imply uncertainty, which means risk.
• Some stakeholders will always push the envelope on the project scope, and each organization has some tolerance for overrunning the objectives. This will mean more cost.

You will need some funds to deal with both of these situations. What comes to your rescue here is called contingency reserve. The contingency reserve, in general, is an amount of resource (funds or time) allocated in addition to the calculated estimates to reduce the risk arising from various sources—for example, from the overruns of project objectives to a level acceptable to the performing organization. In other words, the contingency reserves are the funds reserved to deal with events that are anticipated but not certain. Contingency reserves can be used at the discretion of the project manager. The overall cost estimate should include the contingency reserves.

Vendor bid analysis - Bids from qualified vendors on parts of the project or even the whole project can help in estimating the project cost.

Cost of quality - Cost of quality, should also be considered when making cost estimates. Don't worry about Cost of quality just yet. We will cover it in one of the subsequent chapters.
Three-point estimates - Three-point estimates, discussed in the previous chapter for duration estimates, can also be applied in the same way to cost estimates.

Trivia:
Note that the accuracy of cost estimates depends on many other estimates, such as activity duration estimates and resource requirement estimates, which go into developing the schedule baseline used for making cost estimates. It is important to keep this dependency in mind just in case you need to change any of these estimates.

Output of Estimate Costs Process

The output of the Estimate Costs process consists of:
Activity cost estimates - These are the quantitative estimates of various costs required to complete the project work. Depending on the project and the stage of the project, cost estimates may be documented in summary form or in detail. These estimates include costs for all resources needed to complete the project work, including equipment, facilities, information technology, labor directly applied to the project work, material, and services. Indirect costs and special categories, such as allowances and contingency reserves, must also be included.

Estimate bases - It’s important to document what the bases of the cost estimates were. These may highly depend on the application area of the project. At a higher level, the following elements must be included in the documentation:

• Assumptions made in making the estimates; for example, the labor rate and where this data came from.
• Constraints that affected the estimates; for example, a milestone must be met by a certain date.
• The methods used to develop the estimate; for example, a three-point estimate.
• The uncertainty, such as +10%, and the confidence level must be assigned to an estimate.

In a nutshell, the outcome of estimating costs will include a cost estimate for each project activity and the basis for that estimate, which can be used to determine the project budget.

Determining Project Budget

Determining the project budget is the process of aggregating the cost estimates for all project activities and assigning a timeline to them. Cost aggregation is the technique used to calculate the cost of a whole by summing up the costs of the parts of which the whole is made. You can use the bottom-up estimation technique to aggregate the costs of all the components and activities to calculate the total cost of the project. The timeline assigned to this cost will be important to reconcile the expenditure with the funding limits. The reconciliation may require rescheduling some activities.

The budget is determined by using the Determine Budget process. Look at the picture below:


Most of the items in the input to this process are already described in this chapter. Organizational process assets may include organizational policies and tools for determining the budget. The reserve analysis at budget level includes management reserve in addition to contingency reserve, and you must understand the difference between the two. Contingency reserves are the funds that can be used to deal with the unplanned events that can potentially transpire in case one or more identified risks occur, whereas management reserves are the funds that can be used in case of yet unplanned but future changes in some aspects of the project, such as the project scope.

The approved budget that includes the aggregated cost with timeline is called the cost baseline. The cost performance of the project is monitored, measured, and controlled against this baseline. This is why it’s also called the cost performance baseline. Funding requirements for the project are derived from the cost baseline and the reserve analysis.

Do not leave out the cost of the internal employees of the organization who will work on the project. They are not free, for two reasons: The organization pays for them, and they do not have infinite numbers of hours to put into the project. Their cost to the project will be determined just like any other project role based on the hours of work they will put into the project.

In the process of determining the budget, you may need to update the project schedule, cost estimates, and the risk register.

Your organization may not have the resources to complete all parts of the project. For those parts of the project, you will need to use what is called procurement.

Prev: Developing the Human Resource Plan

Next: Procuring the Project Resources

1 comment:

  1. Amazing explanation ! Thanks for giving such a simple example and elaboration. As a student of Masters, I am required to do my life's first project plan and scheduling and I was so confused with the terms 'cost' and 'budget' right after I did task estimation. This made it so clear. I also found valuable mind maps to support my work at mindmapify dot com which used in conjunction with explanation given here made all the sense. Keep up the good work.

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