Overview of Project Cost Management
Projects cost money. In most cases, a project will be operating with a cost constraint. “Project cost management is the process of estimating how much it will cost to run a project, how the project will be funded and controlling the available budget to ensure no cost overruns”.
Project cost management looks at four cost categories, namely, direct costs, indirect costs, variable costs, and fixed costs.
Importance of Project Cost Management
There is no question that managing project costs are vital to the success of a project. One of the reasons is that cost management provides a framework against which costs can be estimated, tracked and managed. Further, the cost baseline for a project provides a means of monitoring project performance.
It is possible to determine when a project is on or off-track and allows for mitigation of cost overruns. Lastly, cost management for projects promotes transparency in the allocation and outlay of funds. In this case, projects will deliver value to customers and meet obligations to suppliers and stakeholders.
The Project Cost Management Process
There are four main steps in the cost management process which begins during the planning phase of a project.
1. Estimate the Project Costs
Cost estimation is not an exact science. It relies on several elements to refine the process and determine the most accurate cost depending on the stage of the project. These elements include:
- A breakdown of project tasks and activities
- The available industry data
- Using a standardized method for cost calculation
- External expertise and judgment
- Inclusion of known and unknown risks
- Provision for inflation
The Challenge of Cost Estimation
The cost estimation process is not without its hardships. For starters, if your project is groundbreaking and there has never been another like it before, expert judgment cannot help you with determining the cost estimates.
Second, the earlier it is in the process, and the longer the project, the harder it is to estimate. At the time of determining the project costs, a project manager will have identified all the tasks and activities which will be undertaken from start to finish of the project. It is worth noting that the accuracy of project cost estimates become more evident as the project proceeds through its lifecycle.
Usually, at the initiation stage of the project, the range of accuracy falls between -25% to +75%. This range is referred to as the rough order of magnitude (ROM). As the project moves along, the range of accuracy narrows to -5% to +10%.
Last, the expertise of the project manager and team affects how costs are estimated, budgeted for and controlled.
Cost Estimation Techniques
Using the details of the tasks and activities, the project manager can use one of several techniques to estimate the project costs. They include:
- Using Expert Judgment: This draws from the experience of the project manager, the other project team members, experts, and industry knowledge.
- Analogous estimating: uses the project costs of similar past projects. It is essential to consider the characteristics of the previous project under comparison. The project manager will aim to refer to projects with similar scope, budget, duration, and deliverables for the best estimate.
- Parametric estimating: is statistical in nature. The method relies on the relationship of a specific parameter such as unit cost against another variable like mileage or square footage.
- Bottom-Up estimating: estimates the cost of each component of the work from the smallest package and adding up the larger work packages. It is the most accurate estimation method, though it takes time because of the level of details required.
- Three-point estimate: accounts for uncertainty and risk. It considers three points, the best-case cost scenario, worst case cost scenario and most likely cost of the project. The cost is summed up from these three points then averaged.
One formula is called the triangular distribution and looks like this:
(Optimistic + Most Likely + Pessimistic)/3
The other formula is called the beta distribution and looks like this:
(Optimistic + 4Most Likely + Pessimistic)/6
- Contingency Reserve Analysis: As part of the planning process, the project manager will identify risks and allocate a cost to the identified as well as the unknown project risks. The amount set aside for known and unknown risks is the contingency reserve. As information becomes available, the contingency reserve can be utilized, decreased or eliminated.
- Cost of Quality: Refers to the amount of money that is allocated to activities which aim to prevent, measure and fix poor quality in products or services. When estimating costs, it is imperative to include this cost, especially since quality is one of the measures of product or service success.
2. Determine the Project Budget
Using cost estimates, the project manager can determine the project budget. The project budget is a cost projection over the life of the project. As more information becomes available during each phase of the project, the project budget is reviewed and updated. In other words, the project budget is a live document. For easier monitoring, you can use an Excel worksheet or Project Management software. Some of the cost budget items include labor, cost of financing, materials, provision for inflation, equipment, services, facilities or contingency costs.
You need a project budget to provide a cost baseline against which the progress and performance of the project can be measured, monitored and controlled. Further, it communicates to stakeholders how much finance is required and should be approved at each phase of the project. Lastly, the project budget is a tool for controlling the costs of the project.
The elements which influence how the project budget is determined are:
- The cost of previous similar projects as shared by the experts
- The information available from the industry
- The financial principles which will be applied
- Funding sources and requirements. For example, loans, equity or investors
The Process of Project Budgeting
1. Review Historical Data
The costs of a past project with similar characteristics can guide in developing a project budget.
2. Consult the Lessons Learned Report
A good project manager creates and maintains a lessons learned report to share the successes and learning points from a past project. The lessons learned report is, therefore, a good source of data about cost management best practice.
3. Rely on Expert Judgment
Experts in the fields of study related to a project can provide accurate estimates and considerations during the project budget process. They can create awareness of common project cost management pitfalls and how to avoid them.
4. Check and Recheck the Budget
A typing error can mean the difference between a well- funded project and an underfunded one. The project manager needs to ensure that all figures add up correctly, and each project cost is inputted accurately into the project budget template or software.
5. Conduct Data Analysis
Data analysis helps to determine the management reserves. Management reserves are an amount in the project budget, which the management can approve for use in unforeseen circumstances within the scope of the project.
3. Control the Project Costs
One of the measures of project success is delivering the project within the approved budget. To aid this process, the project manager must control the costs to ensure no overruns. This step of the cost management process involves updating costs and re-baselining the project costs where necessary. A project manager can manage and control the project budget by:
- Tracking and updating project costs in real-time
- Noting, investigating and remedying cost variances
- Identifying potential areas of cost overruns and keeping them within acceptable limits
- Monitoring work performance against funds released to confirm the value of the work
- Ensuring the validity of change requests and managing the costs incurred to implement changes
- Monitoring outflow of funds does not exceed approved limits at each stage of the project, for every work package and activity, and overall.
Using a cost tracking template or software, a project manager can record, monitor and update the various project costs. Depending on the type of project, the associated costs may vary. Some of the associated project costs include administrative costs, material costs, software costs, labor costs, travel costs, equipment costs, expert fees, insurance, office space and equipment, communication costs, storage fees, shipping and handling fees.
4. Develop the Project Cost Management Plan
The cost management plan is a part of the overall project management plan which focuses on how costs will be planned, designed and monitored. The cost management plan includes the following elements:
- The units of measure for each project resource, for example, weeks or staff-hours for time
- The acceptable level of exactness of figures, for example, rounding up or down numbers
- The acceptable range of accuracy for costs and estimates, for example, -5% to +15%
- Accounting for the cost of all project activities using project control accounts
- The allowable variance thresholds from the cost baseline
- Establishing how cost performance will be measured
- Identifying the acceptable reporting frequency and formats
- Practices to account for fluctuations in currency exchange rates
Guidelines for Project Cost Management
While project costs may change over the project lifecycle, they are manageable with a few considerations:
- Plan for the Unexpected
All projects face both known and unknown risks, and it is critical to pjj lan for them. When creating your project budget, ensure you prepare for both scenarios. An unforeseen change in legislation, weather conditions, company structure or team make-up, may lead to delays in your project. Planning for the unexpected guides a project smoothly during difficult times.
- Account for Inflation And Currency Exchange Rates
Economies change and shift all the time. The net effect of these changes will impact on the project costs, and it is prudent to create a buffer for these changes. Further, it is beneficial to develop procedures to guide the project on how to handle inflation and currency exchange rates.
- Monitor Costs in Real-Time
Project cost accounting can be time-consuming, especially when handling large projects spanning several years and possibly different jurisdictions. The way around this is to track and update costs as they are incurred using a defined system like an Excel worksheet or project management software. The necessary documentation, like invoices, should back the details of all project costs. Where appropriate, explanatory comments should be included when the outlay is still fresh in the minds of the project team.
- Resolve Variances Promptly
Any project cost variances should be investigated and addressed immediately. This practice reduces the knock-on effect of delayed payments, accruing interest on delays or the project stalling.
- Document Everything
All project-related matters must be documented for audit purposes, posterity and transparency. The project charter helps provide high-level project costs and rationales, while the cost management plan offers details.
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